When you sell depreciable property at a gain, the tax law wants to “recapture” some or all of that gain as ordinary income. Why? Because you previously deducted depreciation against ordinary income. If the gain on sale were all capital gain, you would have enjoyed a double benefit: ordinary deductions (reducing ordinary income) followed by capital gain (taxed at lower rates). Sections 1245 and 1250 prevent this mismatch.
The Problem Sections 1245 and 1250 Solve
Consider a machine purchased for $100,000. You take $80,000 in depreciation deductions, reducing your ordinary income. Your adjusted basis becomes $20,000. You sell the machine for $60,000. Your gain is $40,000.
If the entire $40,000 were capital gain (or Section 1231 gain), you would have deducted $80,000 against ordinary income (saving tax at ordinary rates) and recognized $40,000 of gain at capital gain rates (lower). The mismatch is obvious: you got a tax benefit at ordinary rates, but the “recapture” of that benefit is at capital rates. Sections 1245 and 1250 fix that by recharacterizing gain as ordinary to the extent of prior depreciation.
Section 1245 – Personal Property and Certain Real Property
Section 1245 applies to “Section 1245 property” – generally, depreciable personal property (machinery, equipment, furniture, fixtures) and certain real property (e.g., single-purpose agricultural structures, storage facilities for petroleum products, railroad grading).
The recapture rule in Section 1245(a)(1) is: upon disposition, gain is ordinary income to the extent of the lesser of:
- The amount realized (or FMV if disposition not by sale) minus adjusted basis, OR
- The “recomputed basis” minus adjusted basis.
Recomputed basis = adjusted basis + all depreciation or amortization deductions allowed or allowable. Section 1245(a)(2)(A). In other words, recapture is the full amount of prior depreciation, up to the gain.
In the example above: Adjusted basis = $20,000. Recomputed basis = $100,000. Amount realized = $60,000. The lesser of ($60,000 – $20,000 = $40,000) or ($100,000 – $20,000 = $80,000) is $40,000. So all $40,000 gain is ordinary income – recaptured depreciation. Nothing is left for capital gain.
If the machine sold for $120,000, the gain would be $100,000. Recomputed basis minus adjusted basis is $80,000, so $80,000 is ordinary (recaptured depreciation) and the remaining $20,000 is Section 1231 gain (which may be treated as capital gain).
Section 1250 – Real Property
Section 1250 applies to depreciable real property that is not Section 1245 property (generally, buildings and their structural components). The recapture rule is narrower: only “additional depreciation” is recaptured.
“Additional depreciation” is the excess of depreciation actually taken over straight-line depreciation. Section 1250(b)(1). For most real property placed in service after 1986, MACRS uses straight-line for real estate, so there is no additional depreciation – and thus no Section 1250 recapture. For property placed in service before 1987, accelerated methods were allowed, and Section 1250 recapture may still apply.
If there is additional depreciation, the recapture amount is the lesser of:
- The additional depreciation on the property, OR
- The gain on the sale (including gain that would be recaptured under Section 1245 if the property were Section 1245 property).
Example: A building purchased for $500,000, with $100,000 of straight-line depreciation allowed, but the taxpayer used an accelerated method and actually deducted $150,000. Additional depreciation = $50,000. Adjusted basis = $350,000. Sold for $600,000. Gain = $250,000. The recapture under Section 1250 is $50,000 (additional depreciation). The remaining $200,000 is Section 1231 gain, which may be capital gain (subject to the 25% maximum rate for “unrecaptured Section 1250 gain”).
The “Unrecaptured Section 1250 Gain” – A Special Rate
Even after Section 1250 recapture, some gain on real property is treated as “unrecaptured Section 1250 gain” – the portion that would be recaptured if the property were Section 1245 property, but that is not recaptured because Section 1250 is narrower. For individual taxpayers, unrecaptured Section 1250 gain is taxed at a maximum rate of 25% (not the general capital gains rate of 20% or the 28% collectibles rate). Section 1(h)(1)(E).
In the example above, after the $50,000 recapture, the remaining $200,000 gain includes “unrecaptured Section 1250 gain” equal to the straight-line depreciation taken ($100,000). That $100,000 is taxed at 25% max. The other $100,000 is long-term capital gain taxed at 20% max (or lower). This is complex, but software handles it.
Exceptions to Recapture
Both Sections 1245 and 1250 provide exceptions for certain dispositions:
- Gifts – No recapture at the time of the gift; the donee takes the donor’s basis and “steps into the shoes” for future recapture. Section 1245(b)(1); Section 1250(d)(1).
- Transfers at death – No recapture; the beneficiary receives a stepped-up basis under Section 1014, and the recapture potential disappears (a significant planning opportunity). Section 1245(b)(2); Section 1250(d)(2).
- Like-kind exchanges and involuntary conversions – Recapture is deferred to the extent boot is not received; the replacement property takes the recapture potential of the old property. Section 1245(b)(4); Section 1250(d)(4).
- Tax-free corporate reorganizations – Generally no recapture; the successor corporation takes the recapture potential. Section 1245(b)(3); Section 1250(d)(3).
Interaction with Section 1231
Section 1231 provides that gains from the sale of depreciable property held for more than one year are treated as capital gains (subject to the recapture provisions of Sections 1245/1250). The recapture sections override Section 1231: to the extent gain is recaptured as ordinary income, it is not Section 1231 gain. Only the remaining gain (if any) enters the Section 1231 hotchpot.
In practice, for real property placed in service after 1986 (straight-line MACRS), there is no Section 1250 recapture. However, gain up to the amount of straight-line depreciation is “unrecaptured Section 1250 gain” subject to the 25% rate. This is not “recapture” (it’s not ordinary income) – it’s just a higher capital gains rate. The distinction matters because unrecaptured Section 1250 gain can be offset by capital losses, while recaptured ordinary income cannot.
Planning with Recapture
Taxpayers selling depreciable assets should be aware of the recapture potential. Selling in a year with capital losses may not help – recaptured ordinary income cannot be offset by capital losses. Selling in a year with net operating losses may shelter the recapture, but NOLs are limited.
One planning technique is to use a like-kind exchange under Section 1031 (for real property) to defer both gain and recapture. The replacement property takes the basis of the old property plus any boot paid, so the recapture potential carries over. Eventually, if the property is held until death, the basis step-up eliminates the recapture entirely. For personal property, Section 1031 was repealed for exchanges after 2017, so that deferral option is gone.
Sections 1245 and 1250 have successfully prevented the deduction/capital gain mismatch. For most real property placed in service after 1986, the recapture rules are minimal (since depreciation is straight-line). For personal property, full recapture applies. The result: depreciation deductions save taxes at ordinary rates, and any gain on sale attributable to those deductions is “recaptured” as ordinary income – a fair matching of character.
Disclaimer: This article provides general information for educational purposes only and does not constitute legal advice. Tax laws, judicial interpretations, and IRS guidance are subject to change at any time through legislation, regulation, or court decision. Readers should consult Alan Goldstein & Associates for advice regarding their specific factual situations.
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